Permafrost plc needs a new computer network but is uncertain whether to buy the system or to lease it from Slush plc. The system will cost £800,000 if bought and Permafrost plc would borrow to finance this. Information on the two options is as follows:
Option 1
If the system is leased, Slush plc will receive an annual lease payment of £150,000, paid in advance. Slush plc will service the system, at no additional cost, over its eight-year life.
Option 2
If the system is bought, Permafrost plc will service the system at an annual cost of £10,000.
It has a choice of three financing methods:
1 It could issue 12 per cent bonds, secured on existing non-current assets, to be redeemed in eight years' time at nominal value of £100 per bond.
2 It could raise an eight-year floating rate bank loan, secured on existing non-current assets, to be repaid in equal instalments over its life.
3 It could issue zero coupon bonds, to be redeemed at £100 nominal in eight years.
Permafrost plc pays tax one year in arrears at an annual rate of 30 per cent and can claim capital allowances on a 25 per cent reducing balance basis. The before-tax cost of debt of the company is 10 per cent and this is not expected to change as a result of the financing choice made in connection with the new computer network.
(a) Calculate the market values of the 12 per cent bond issue and the zero coupon bond issue, and analyse and critically discuss the relative merits of the three debt finance methods to Permafrost plc.
(b) Evaluate whether Permafrost plc should lease or buy the new computer network.